The Effect of 2002-08 on Split Dollar

Feature: The Effect of 2002-08 on Split Dollar

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By Philip J. Straub

The notice sets preliminary rules on how to treat existing and new split-dollar arrangements.

On Jan. 3, 2002, the IRS published Notice 2002-08 in an attempt to clarify the rules for split dollar. In TAM 9604011, Notice 2001-10 and Notice 2002-08, the agency targeted the so-called "equity split-dollar" arrangements because it felt that the employee was receiving an economic benefit (the cash surrender) that was not contemplated in prior rulings on split dollar. Notice 2002-08 has two important consequences: It revokes Notice 2001-10 published in early 2001, and repudiates TAM 9604011, which caused participants in split-dollar arrangements great concern.

The bottom line of this new notice sets preliminary rules on how to treat existing and new split-dollar arrangements. The contents of this notice are preliminary because the IRS announced it will publish final regulations to establish the ultimate rules for split-dollar arrangements. Until then, we have some relatively clear rules to follow in dealing with existing plans and any new plans established.

The new IRS notice offers guidance on grandfathering, transition and safe-harbor rules.

However, there are some important dates to use in determining what is an existing plan and what is a new plan. The first key date is unknown. Notice 2002-02 states that its rules will apply in full to split- dollar arrangements entered into after the date of publication of final regulations. Obviously, we do not now know what that date will be. The other important date is Jan. 28, 2002. For split-dollar agreements entered into before that date, the notice contains some grandfathering, transition and safe-harbor rules that can be used to preserve the essential aspects of any existing agreement.

Rules for split dollar after final regulations
Notice 2002-08 clearly states how split-dollar plans adopted after publication of final regulations will be treated for tax purposes. The notice creates two mutually exclusive tax treatments. The method that will be used will be determined by which party to the agreement is "formally designated" as the owner of the life insurance contract. If the employer is the formal owner, the tax treatment will be according to Sections 61 and 83 of the Internal Revenue Code. This form is the classic "endorsement-method" split dollar. If the employee is the formal owner, the treatment will be according to Section 7872 and, where applicable, Sections 1271-1275. This form is the classic "collateral-assignment" split dollar. Let's first examine the rules for endorsement-method split dollar.

Employer as owner of life contract
Under endorsement-method split dollar, the employer is the owner and premium payer of the contract and provides death benefits to an employee through a formal endorsement of the death benefit in the contract. The death benefit thus provided has an economic value, which must be imputed to the employee under Section 61 of the Code.

It revokes Notice 2001-10 and repudiates TAM9604011, which caused participants in split-dollar arrangements great concern.

The value of this benefit must be determined using the Table 2001 rates. Any other economic benefits provided through the arrangement are also taxable to the employee under Section 61. For example, if the employee has a claim to cash value that exceeds the employer's premium payments, this amount will be taxed to the employee. If the arrangement is terminated and the policy is transferred to the employee, the value of the policy is taxable to the employee under Section 83 of the Code. The employer will receive a corresponding deduction for the value thus transferred.

Employee as owner of life contract
In collateral-assignment split dollar, the employee is the owner of the contract while the employer is the premium payer. The employee typically executes an assignment of death benefit and cash value equal to the sum of premiums paid by the employer. This amount will be repaid at the death of the insured or the surrender of the policy. Under the rules of Notice 2002-08, premiums paid by the employer are a series of loans to the employee and are taxable under the provisions of Section 7872 and, if applicable, Sections 1271-1275 of the code.

Section 7872 deals with compensation-related, below-market loans and calls for a deemed transfer of loan interest from the employee to the employer that is funded by a taxable transfer of the same amount from the employer to the employee. Thus, the employee will report as taxable income an amount equal to the interest on the premium payment that is below the Applicable Federal Rate (AFR). Since split-dollar agreements do not typically have an interest rate connected to the payment of premiums by the employer, the amount of the taxable income and deemed payment to the employer will be the premium multiplied by the AFR. If the premium payment is $10,000 and the AFR is 6 percent, the employee will report a taxable income of $600 and will be considered to have made an interest payment to the employer of $600. This would be considered loan interest connected with the purchase of a life insurance policy and would not be deductible under Section 264 of the Code.

If there is no provision for the repayment of premiums from death proceeds or cash value, the premium payments will be considered additional taxable compensation to the employee when each premium is paid. The notice also explicitly states that these same principles will apply to any split- dollar arrangement in "other contexts, including arrangements that provide benefits in gift and corporation-shareholder contexts." This appears to make the mutually exclusive approaches applicable to private split dollar, charitable split dollar and reverse split dollar.

All of the above will be in full force once final regulations are published. Until then, the notice provides guidance on the tax treatment of existing split-dollar arrangements.

Rules for existing split-dollar plans
As mentioned earlier, the notice provides certain grandfathering, transition and safe-harbor rules for split-dollar arrangements entered into before final regulations are published. There is a distinct dividing line as of Jan. 28, 2002. Plans entered into before this date and after this date have one set of rules. For the purposes of which term rates to use to value life insurance protection, plans entered into after Jan. 28, 2002, have slightly different rules. Thus, we will now explore two plans: those entered into before Jan. 28, 2002, and those entered into before final guidance is issued on the term rates for imputed economic benefit.

Arrangements before Jan. 28, 2002--
endorsement method (employer as owner)
The notice appears to make no significant changes to existing endorsement split-dollar agreements entered into before Jan. 28, 2002. The IRS will not consider these arrangements to have been terminated as long as the affected parties continue to report the imputed economic benefit to the employee for as long as the split-dollar arrangement continues. Should the employee under an endorsement-method split dollar have claim to any cash value in the policy, the IRS will not deem a taxable transfer of cash value to the employee "…solely because the interest or other earnings credited to the cash surrender value of the contract cause the cash surrender value to exceed the portion thereof payable to …" the employer.

Collateral assignment (employee as owner)
For collateral-assignment, split-dollar arrangements entered into prior to Jan. 28, 2002, the notice provides three alternatives:

1. The parties may immediately transform the agreement into a series of loans from the employer to the employee. With this alternative, all premium payments made prior to changing to the loan approach must be treated as loans at the beginning of the year in which the agreement is transformed, and reasonable attempts must be made to comply with the requirements of Sections 7872 and 1271-1275.
2. The parties may continue the collateral-assignment structure and terminate the agreement prior to Jan. 1, 2004. Under this alternative, the IRS will not treat the cash value owned by the employee as taxable under Section 83 of the code.
3. The parties may continue the collateral-assignment structure but must transform the arrangement into the loan approach for all years beginning Jan. 1, 2004. Any cash value owned by the employee will not be considered as taxable under Section 83. To meet the terms of this alternative, all premium payments made by the employer prior to Jan. 1, 2004, must be treated as loans, and the parties to the arrangement must report the tax treatment consistent with the requirements of Sections 7872 and 1271-1275.

Arrangements entered into before publication of final guidance
One major effect of Notice 2002-08 on existing split-dollar arrangements deals with what rates can be used to value the imputed economic benefit. The basic rules already outlined apply to plans adopted after Jan. 28, 2002, but before publication of final regulations or publication of final guidance on term rates. The notice refers in several places to "final guidance" on how to value life insurance protection provided under a split-dollar arrangement. The transition rules for valuing life insurance protection provided under a split-dollar arrangement can be summarized as follows:

1. The insurer's one-year term rates may continue to be used for agreements in place prior to Jan. 28, 2002. However, for arrangements entered into after Jan. 28, 2002, but before final guidance is published, these rates may be used only if they are rates for a legitimate insurance policy. To be legitimate, the insurer must make these rates available and must regularly sell term insurance at these rates through its normal distribution channels. These requirements for legitimacy will be effective Jan. 1, 2004.
2. The parties to a split-dollar arrangement may use the Table 2001 rates first published in Notice 2001-10 and restated in Notice 2002-08. However, appropriate adjustments should be made for any split dollar arrangement that covers more than one life. The notice gives no guidance for what these adjustments should be.
3. For arrangements entered into prior to Jan. 28, 2002, in which the parties have agreed to use PS 58 rates for calculating the economic benefit, PS 58 rates may continue to be used. The requirement for this provision is that the life insurance protection must be provided to the employee (or to the employee and one or more additional persons ...) [Emphasis added].

The notice clearly states that final regulations and guidance will be issued, but does not state when. Apparently the IRS intends to publish these final documents soon because it states that written comments on Notice 2002-08 must be submitted no later than April 28, 2002. In light of what appears to be a short timeframe, existing split-dollar arrangements should be examined with an eye toward the impending changes.

The following section addresses some suggestions and recommendations on what to do with existing split-dollar arrangements. Neither Pan-American Life nor any of its representatives are allowed to give tax advice; so, qualified tax counsel must review the following.

What to do about existing split-dollar plans
Because there are different forms of split-dollar plans in existence, this section will deal with each individually--endorsement-method split dollar, collateral-assignment split dollar and reverse split dollar. Because some aspects of the notice are not clear, we will make some assumptions about the intent of the notice and take a conservative approach in constructing what the writers meant.

Endorsement-method split dollar
There are two general forms of endorsement--death benefit only, and death benefit with cash value. No radical changes need to be made to the structure of classic endorsement split dollar. This structure complies with all major requirements of Notice 2002-08. The employer is providing death benefits only and no cash value. The current value of the death benefit is taxable to the employee under Section 61 of the code. For tax year 2002, the parties in this form of split dollar should determine the least expensive term rates to use to value the life insurance protection. In many cases, that will be the new Table 2001. However, the table rates should be compared to the insurance company's term rates at all ages, not just the current age. The rates selected should be the ones that yield the lowest overall cost to the employee through the expected term of the endorsement, taking into consideration the employee's current and anticipated future tax brackets. We believe that the IRS will apply the "legitimacy" test to all uses of the carrier's term rates so the parties should verify that the company term rates are for a policy that is available and generally sold through its normal distribution channels.

Collateral-assignment method split dollar
Although many design techniques have been used for collateral-assignment split dollar, they all share a common thread. The employee owns the life insurance contract, and the employer maintains a claim against death benefit and/or cash value. In the traditional equity split-dollar design, the employer's claim is equal to the sum of premiums paid, and the employee owns the balance of the death benefit and cash value. Notice 2002-08 provides three alternatives for existing collateral assignment:

1. The parties may immediately transform the agreement into a series of loans from the employer to the employee and account for the arrangement appropriately. This must include all previous premium payments by the employer as loans when the arrangement is transformed, and the parties to the arrangement must report the tax treatment consistent with the requirements of Sections 7872 and 1271-1275.

2. The parties may continue the collateral-assignment structure but must transform the arrangement into the loan approach for all years beginning Jan. 1, 2004. Any cash value owned by the employee will not be considered as taxable under Section 83. All prior premium payments by the employer must be treated as loans and the parties to the arrangement must report the tax treatment consistent with the requirements of Sections 7872 and 1271-1275.
3. The parties may continue the collateral-assignment structure and terminate the agreement prior to Jan. 1, 2004. Under this alternative, the IRS will not treat the cash value owned by the employee as taxable under Section 83 of the Code when the plan is terminated.

One viable approach is to use the third option and have the employer make substantial premium payments before Dec. 31, 2003. On Dec. 31, 2003, the employer can be repaid and the split-dollar agreement terminated. According to the rules of the notice, all remaining cash value will not be taxable to the employee under Section 83. On Jan. 1, 2004, a new split-dollar arrangement can be put in place, which will comply with the requirements of the final regulations, assuming they have been published.

Reverse split dollar
Reverse split dollar will require the greatest care and analysis because the notice does not directly address many of the design techniques used in a reverse split-dollar agreement. Under this plan, an employee owns the life insurance contract and has assigned a portion of the death benefit back to the corporation for a specific period. The employer then pays true PS 58 costs for the insurance protection provided by the employee from his or her policy. In some cases, the employer will actually "prefund" the PS 58 costs and expense any overpayments in future years. At the end of the assignment period, full control of the death benefit reverts to the employee who has full access to any cash value created by the employer's payment of PS 58 costs.

The new rules of Announcement 2002-08 clearly indicate that if a life insurance policy is owned by the employee, premium payments made by the employer must be treated as loans from employer to employee and a like amount as an interest payment from the employee to the employer. The amount of interest that is less than the interest required by using the AFR is taxable to the employee. Thus, it would appear that the reverse split-dollar payments by the employer that exceed the cost of the benefits would be treated as loans and taxable to the employee.

The notice does contain a provision that impacts reverse split dollar positively. It states that for any split-dollar agreement adopted prior to Jan. 28, 2002, in which PS 58 rates are used to value the current insurance protection provided, the parties may continue to use PS 58 rates. To qualify, the agreement must provide "current life insurance protection … [to]… the employee (or to the employee and one or more additional persons)..." "Person" is defined in Internal Revenue Code Section 7701 as "an individual, a trust, estate, partnership, association, company or corporation." Because the corporation is considered a "person," an existing reverse split dollar would appear to be eligible to use PS 58 rates.
This leaves us with several alternative approaches:

1. The corporation could continue to pay for the protection afforded it but at a rate not greater than the PS 58 rate for each subsequent. Any payments in excess of this amount could be treated under the loan provisions of the notice. Since this approach would be looked at as a series of loans but the loans do not exceed the cost of the benefit, cash value growth should not be taxable to the employee.
2. In cases in which prefunding is used, the corporation could prefund all future PS 58 costs in a single payment this year. For this year only, the excess over this year's PS 58 costs could be construed as a loan. However, because the prefunding is a prepayment of known future costs, an argument can be made that this is a capitalized expense and not a distribution to the employee. Under the terms of the notice, the IRS has stated that it "will not treat a service recipient (the employer) as having made a transfer of a portion of the cash surrender value of a life insurance contract to a service provider (the employee) for purposes of Section 83 solely because the interest or other earnings credited to the cash surrender value of the contract cause the cash surrender value to exceed the portion thereof payable to the service recipient (the employer)." This should preserve the nontaxable growth of values attributable to the employee.

Ever since the publication of TAM 9604011, insurance practitioners have been unsure of what to do for existing and new split-dollar arrangements. Many people view both TAM and Notice 2001-10 as draconian. Notice 2002-08 at least clears up many issues raised in TAM and in the earlier notice. Parties in any split-dollar arrangement now have some semi-concrete guidance. As always with the IRS, things will never be totally clear until final regulations are published, and several gray areas remain. However, in Notice 2002-08 we at least have guidance on grandfathering and transition.

Philip J. Straub, second vice president at Pan-American Life, is responsible
for assisting producers in working in advanced business markets. You can reach him at pstraub@wewill4u.com or at 1-877-939-4558, ext. 3457.

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